Supreme Court clamps down on use of tax loopholes

Supreme Court of Canada upholds use of General Anti-Avoidance Rule against Li family's Copthorne Holdings unit

The Supreme Court of Canada has ruled against Li Ka-Shing and his son Victor Li in an important tax case that sheds light on when the government can invoke a powerful loophole-plugging provision of the Income Tax Act called the General Anti-Avoidance Rule or GAAR.

In a case called Copthorne Holdings Ltd. v. Canada, the court affirmed that the tax department has the statutory power to deny a taxpayer any benefits that accrue from transactions that are conducted primarily for purposes of exploiting loopholes in the law.

In a unanimous written decision from the nine-judge court, Mr. Justice Marshall Rothstein found that a series of dealings made by Copthorne, a holding company associated with the Li family, was structured to frustrate a provision of the act that sets out the tax treatment for corporate amalgamations. “The transaction was therefore abusive and the assessment based on application of the GAAR was appropriate,” he concluded.

The anti-loophole provision, found in section 245 of the Income Tax Act, is controversial because it generates uncertainty. Some legal commentators have called it a “smell test” that gives the government the power to disallow the tax benefits from clearly abusive transactions.

“This is a reaffirmation of GAAR,” said Donald Bowman, a former chief justice of the Tax Court of Canada who is now counsel in the national tax group of Fraser Milner Casgrain LLP. “It’s a very well written articulation of the concept of GAAR. If things had gone the other way, I don’t quite know where GAAR would stand.”

Gabrielle Richards, a tax practitioner with McCarthy Tetrault LLP in Toronto, described the decision as “clear, sequential and logical,” and said it does much to address the uncertainty that was left in the wake of some earlier decisions that dealt with GAAR. She describes the decision as the court’s way of saying: “Here is the approach to take. You guys go away and apply it. Don’t come back to the Supreme Court again, because we’ve now told you clearly how it works.”

Another McCarthy partner, Chia-yi Chua, said the decision will embolden the Canada Revenue Agency in its efforts to enforce GAAR. “We predict that given the victory that the CRA secured here, 9-0, GAAR will be used more in the coming days to shore up CRA assessments of a technically borderline nature.”

Judge Rothstein’s ruling is alive to concerns over the uncertainty. His decision recognizes that taxpayers are entitled to organize their affairs so as to minimize their tax burdens. He cautions that GAAR is a provision of last resort and that the government should apply it only when transactions are clearly abusive. The analysis should not be guided by “moral opprobrium,” but rather a three-part test for abuse, which is set out in paragraph 72. He puts the onus of meeting the test squarely on the government:

The analysis will then lead to a finding of abusive tax avoidance: (1) where the transaction achieves an outcome the statutory provision was intended to prevent; (2) where the transaction defeats the underlying rationale of the provision; or (3) where the transaction circumvents the provision in a manner that frustrates or defeats its object, spirit or purpose. These considerations are not independent of one another and may overlap. At this stage, the Minister must clearly demonstrate that the transaction is an abuse of the Act, and the benefit of the doubt is given to the taxpayer.

Some observers say the decision is actually pro-business. The tax act does not give the government access to invoke GAAR to deny the tax benefits of transactions which have been made for primarily bona fide purposes. This leaves the door open for tax planners to structure corporate reorganizations that may have tax benefits, said David Spiro, counsel with FMC Law in Toronto:

“Corporate Canada will still be able to engage in tax planning to advance business objectives if the transactions contemplated are adequately supported by non-tax purposes and if the results of those transactions do not circumvent any provisions of the Income Tax Act that are clearly aimed at precluding those results.”

And while the decision offers some clarity on when GAAR can be invoked, there will never be a way to provide perfect certainty when it comes to GAAR says Adrienne Woodyard, associate counsel with Davis LLP in Toronto. “As much as taxpayers desire and require consistency and predictability in planning their affairs, the GAAR is, and remains, a bit of a wild card.”

Copthorne was an entity the Li family used for various purposes over the years. One use was to capture a tax loss on the value of its shares in Calgary-based Husky Oil Ltd. and another use was to shelter a capital gain from the sale of the Harbour Castle Hotel in Toronto in 1989.

The government argued that through a complex series of transactions involving Copthorne and other entities, the family realized a deemed dividend of $58.3-million in 1994. The government therefore claimed it was owed withholding taxes amounting to $8.7-million, plus a 10% penalty.

The Canadian government invoked the GAAR provision to claim the amount it felt it was due. Copthorne challenged this in the Tax Court of Canada, but that federal court sided with the government in 2007. This decision was upheld by the Federal Court of Appeal in 2009. The Supreme Court heard the case early this year and released its decision Friday.